Why GDP Isn’t a Good Proxy for Ability to Pay Muni Debt

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Photo by: John Carney

The big question on everyone’s mind when it comes to municipal bonds is simple: Will states and cities be able to pay their interest and principal on time, and in full?

Unfortunately, no one really knows the answer. The source of our ignorance, ironically, is the historical strength of muni bonds—the low default rates. So few muni bonds have defaulted historically — only four major cities in 40 years, and zero states — that we just don’t know what metrics to use to predict defaults.

One metric popular among the bullish crowd strikes me as highly inappropriate—muni debt as a percentage of GDP. Let’s call this MGDP for short. This is popular among the muni bulls because it seems to show that current muni debt — which is around 16.7 percent of GDP — is what it was in the mid-1980s and mid-1990s.

Municipal Bond Maze - See Complete Coverage
Municipal Bond Maze - See Complete Coverage

The problem is that states do not have access to all of GDP in servicing their debts. If the share of GDP states can access for debt service is declining, then MGDP will paint an overly rosy picture of the ability of states to pay.

Why might a state’s access to GDP for debt service decline? There are a number of reasons.

  • Federal taxes. If these rise, the states will find their own base of taxable income declining.
  • Public sector pension funds and benefits. Money that must be collected to pay for these cannot be accessed for debt service.
  • Health care, housing and food. It’s unlikely that a state will be able to raise taxes if such increases would reduce the access of its citizens to such basic necessities.
  • Globalization. Competition for jobs from abroad will limit the ability of states to raise the share of individual and business income they collect to service their debt.

Any realistic assessment of state finances has to take into account the fact that each of these factors is likely to grow over the next few years. Which means that the percentage of GDP available to service muni bonds will decline.

What we really need is some kind of debt service coverage ratio that will compare the unencumbered potential revenues of states to their debt service costs.

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